Money1

Rajeet Guha

A.1 Money is any item that people are generally willing to accept in exchange for goods,

services and financial assets such as stocks or bonds. It is anything that acts like money. These days paper money acts like money. Earlier in the past coins of gold, silver and copper were used as money. Knife money, ring money, cigarettes, tobacco, beaver pelts, wampum, shells, bags of barley or wheat closed with the sovereign’s seal stamped on it to guarantee weight. Salt was also used as money.
Money has several functions. First money functions as a medium of exchange. This means that people who trade goods and services and financial assets are willing to accept money in exchange for these items. It saves the cost of bartering goods. Money has other important functions. It can be used as a store of value. Money could be held for future use without loss of value in the meantime. Money also functions as a unit of account, which means that people maintain their financial accounts by using money to value goods, services and financial assets. Americans keep their accounts in dollars while Japanese keep theirs in Japanese yens while the English keep theirs in pound sterling. Money also serves as a standard of deferred payment. People agree to loan contracts that call for future repayment in terms of money.
Money has several characteristics. First it must be durable. It needs to last over time. Raw fish can’t be used as money. It must be divisible into small amounts. It must have small denominations. It should be neither too abundant nor scarce. In case it is scarce then interest rates and the cost of making money would go up. If it were too abundant then everybody would be a billionaire. Sea shells or dirt can’t be used as money. It must be portable. It must have a high value to weight ratio. It must be recognizable. Everyone must know that it is money. It must be standardizable. It must be a known purity and it must be hard to counterfeit.
Money has an internal contradiction. It has a use-value and an exchange value. Use value refers to money’s intrinsic worth as a commodity. Exchange value refers to the value or price that money fetches in the market.
The two costs involved in making transactions are transactions costs and waiting costs. These two costs make up the total costs of conducting transactions. The transactions costs refers to the physical amount of time it takes place for the transaction to take place. Waiting costs refer to the cost of waiting for the seller after he has sold his good to the buyer to be offered an acceptable good in exchange.
An economy would prefer to use money instead of a non-monetary system because of reduced transactions and waiting costs. The total costs of conducting transactions are greatly reduced by a monetary economy. It is diagrammatically expressed in Fig. 1. A monetized economy does not require a double coincidence of wants like barter. It does not require a direct exchange of wants. It saves us from bartering which is extremely inefficient and expensive. Besides it becomes complicated and cumbersome in case where an economy produces vast amount of goods as it becomes difficult to keep track of innumerable prices where prices is given by the formula:
No. Of prices = N (N-1) / 2 where N denotes the number of goods.
Fiat money will generally be preferred to commodity money such as specie, gold coins and, money backed by a commodity standard such as the gold standard. It will be preferred as interest rates cannot be raised in a commodity standard and there is a limit to amount of social expenditure conducted by the govt. for the public as it would lead to inflation and decrease the quantity of gold redeemable to the public when public debt has to be paid. The economy where a commodity standard backs money or an economy that has commodity money would also be prone or sensitive to fluctuations in the price or quantity of gold in the economy. In contrast to this fiat money has none of these problems. Besides transactions and waiting costs are the least in using fiat money than in any other system.
Money is responsible for the modern world because in the absence of a durable, portable, divisible, scarce, recognizable standard of exchange it would be impossible to conduct the enormous, infinite and continuous, non-stop transactions of the world with such rapidity on a global scale without money. The transactions costs, waiting costs and the number of prices to keep track of would be too high for exchange of goods and services to take place.
A.3 Money is defined as a universal equivalent according to the Marxist conception of money. However, in order to come to such a hypothesis one must define a commodity. A commodity is a product, which is the private property of a private agent or individual and which is bargained in the process of exchange over other commodities. This is how the distribution system of products works in a capitalist economy where privately owned commodities are exchanged for a profit.
According to Marx commodities have a dual nature. It has a use-value or can directly be used or consumed by the owner, which is its first aspect. The second aspect is that the commodity can be exchanged for other commodities in the market. This exchangeability for other products is its exchange-value. Exchange-value can often be and often is different from use value. Exchange value or value refers to the price of a commodity in neoclassical economics.
Therefore if exchange-value is different from use value and if the commodity’s intrinsic worth or use-value does not determine its exchange-value or value or price, then there must be some common factor, which determines its exchange value. It was the great Adam Smith, the father of economics, who proposed that exchange-value is determined by labor expended in a commodity. Thus was born the labor theory of value. The labor theory of value was subsequently enriched and refined by Ricardo, and then Karl Marx. According to Marx, only the abstract, simple, socially necessary labor time determines the exchange value or simply value or price which is manifested as money necessary to purchase the commodity in a market. Money is an expression of this value in a commodity and it is different and specific to every commodity. Money is an expression of this value alienated or separated from any particular commodity. The money value added of the mass of commodities newly produced and exchanged in an economy constitutes the total value added of all newly produced commodities. According to Marx simple barter expresses the accidental/ elementary form of value such as 20 yards of linen = 1 coat. Linen expresses its value in the coat. The coat is passive. It is the material in which the linen expresses itself. The value (exchange value) of the linen is expressed by the material of the coat (1 yard of linen = 1 / 20 of a coat). The linen is in a relative position and the coat is in a equivalent position. The coat is a particular equivalent for the linen. The elementary form of value quickly develops into the expanded form of value in which one commodity is equated to the whole range of other commodities, each of them in turn expressing its value. This change corresponds to a change in perspective from an individual exchange to a consideration of the whole system of commodity exchange. Marx expresses the expanded form of value as 20 yards of linen = 1 coat = 10 pounds of tea = 1 / 2 ton of iron. In this form, the value of linen is mirrored in all other commodities. Therefore 20 yards of linen is the universal exchange value or money as it is the general equivalent measure of the value of all other commodities. Thus money is embodied in the barter system. This general equivalent form brings us very close to the general / money form of value. When some commodity or abstract unit of account becomes socially accepted as the general equivalent and is commonly used as a measure of the value of all commodities and thereby becomes money such as for example 2oz. Of gold = 20 yards of linen = 1 coat = 10 lbs. Of tea = 1 / 2 ton of iron. Thus 2 oz. Of gold is commodity money, which is the universal equivalent, or value that expresses itself in all other products.
A.4 Let us assume that an economist is stranded on an island with 100 non-perishable pineapples with two months to survive on the island. He charts out his consumption possibilities. He could either consume 100 pineapples in the first month and nothing in the second month or nothing in the first month and 100 in the second month or he could opt for any combination on the consumption possibilities line (Fig. 2) such as 50 in the first month and 50 in the second. The economist, however, is trained to think in terms of utility and indifference curves. He moves away from the realm of reality for a moment and thinks of three combinations among which he would be indifferent, as they would yield the same satisfaction or utility. The three points that belong to the set of indifference curve 1in Fig. 3 are (70,40), (40,60) and (20,90) where the first point in a pair denotes pineapples consumed in the first month and the second point denotes pineapples consumed in the second month. The law of diminishing marginal utility makes the indifference curve convex.
The economist then imagines what would happen if he could consume 10 extra pineapples in the first month without giving up any pineapples in the second month. This would tantamount to a higher indifference curve 2 and therefore greater utility and happiness. The economist then imagines a hypothetical situation where he could consume 10 less pineapples in the first month without any compensatory increase in the second month. This would lead to an indifference curve 0 which is below indifference curve 1 and therefore yields least utility. All these 3 indifference curves can be graphed in Fig. 4
The economist snaps out of his reverie about hypothetical indifference curves. Nevertheless his daydream has helped him to figure out how to decide. In Fig. 5 he draws the consumption possibilities line and the three indifference curves. The points A’’, B’’, C’’ on indifference curve 0 and B on indifference curve 1 are all attainable. The point B on indifference curve 1 is at a higher utility than at any point on indifference curve 0. A is his optimal choice. Combinations on indifference curve 2 are not attainable. The economist notes that at point B the slope of the indifference curve is equal to the slope of the consumption possibilities line, which is 1(1 pineapple must be given up in the first month to obtain 1 pineapple in the second month). However, the economist also discovers that for every two pineapples saved (not consumed) planted in the first month will yield three pineapples in the second month. He then draws his production opportunities set where he can either consume 100 pineapples in the first month or he can plant 100 pineapples in the first month and get 150 pineapples in the second month. The economist’s production opportunities set represents his extended consumption opportunities set. The slope of his production opportunities set is 2/3. The slope of the production opportunities set represents the rate of exchange of first month pineapple consumption for second month pineapple consumption. The reciprocal of this rate of exchange is 3/2, which is the rate of second month pineapple consumption for first month pineapple consumption. He draws these graphs in Fig.6
The economist realizes that he can use and save pineapples in the present to create pineapples in the future. Therefore pineapples function as capital goods besides consumption goods. Economists refer to the amount of output yielded by a unit of capital as the marginal product of capital, which is 3/2.
In fig. 7 the economist draws his original consumption possibilities set as well as his production / new consumption possibilities set along with indifference curve 1 and indifference curve 2. The point B’ on indifference curve 2 will yield greater satisfaction or utility or happiness than any point on indifference curve 1 because it is on a higher indifference curve. At B’ the indifference curve 2 is tangent to the new consumption / production possibilities set where the optimal combination is (50,75) or eat 50 pineapples in the first month, save 50 pineapples and plant them in the first month which would give 75 apples in the second month. Instead if he had not planted the 50 pineapples and merely saved them for the second month then only 50 pineapples would be available for the second month. The total return from saving is therefore 25 pineapples. The rate of return from saving is the total return from saving divided by the total number of pineapples saved that is 25 / 50 or 0.5 or 50 %. The rate of return from saving or the rate of interest is 50 %. This is how interest rates are determined through personal preferences as manifested via indifference curves in the island model.
A.5 The risk structure of interest rates refers to the relationship among yields on financial instruments that have the same maturity but differ on the basis of liquidity, default risk and tax considerations. Default risk is the risk or chance that an individual or a firm that issues a financial instrument may be unable to honor its obligations to repay the principal and / or interest payments. The default risk of U.S. treasury securities is virtually zero. The default risk of corporate bonds is much higher. The amount by which the corporate bond rate exceeds the Treasury Bond rate because of greater default risk is the risk premium. Default risk clearly is an important consideration in bond purchases. Two predominant institutions that rate the risks of bonds are Standard & Poor’s & Moody Investor’s Services. Two of these bonds are investment grade securities (bonds with relatively low risk) and junk bonds (bonds with relatively high default risk). Another reason that corporate bond rates exceed interest rates on U.S. treasury bonds of identical maturities is that traders regard corporate bonds as less liquid financial instruments than Treasury securities. This is because the secondary market for treasury securities is well developed while the secondary market for corporate bonds is not well developed. The higher corporate bond rate compensates for the less liquidity of corporate bonds. There is also a liquidity premium that accounts in part for the difference in interest rates between two bonds with identical maturities. Junk bonds have higher interest rates than investment-grade securities because they are less liquid and therefore contain a liquidity premium.
The island model was unable to account for these issues because:
1) In the island model the principal on pineapples can’t go bad. Therefore, his investment on pineapples cannot go bad in the island. Therefore, there is no risk of investment going down. Yield of a bond may go down dramatically in the real world but in this case yield will not go down in the island. Secondly, there is no choice or portfolio diversification as he can only eat pineapples for an extended period whereas in the real world there is a lot of diversification and there is competition between the different instruments, which determine the price of these instruments. Thirdly there was a specific time span of his investments maturing after the end of the first month. In the real world the time span of bonds and shares is much longer. There is unlimited liquidity in the island. Therefore, there is no liquidity premium. The question of risk has not been factored here. Therefore, there is no risk premium.